Aside from factors such as interest rates and inflation, the exchange rate is one

of the most important determinants of a country's relative level of economic

health. Exchange rates play a vital role in a country's level of trade, which is
critical to most every free market economy in the world. For this reason,
exchange rates are among the most watched, analyzed and governmentally
manipulated economic measures. But exchange rates matter on a smaller scale
as well: they impact the real return of an investor's portfolio. Here we look at
some of the major forces behind exchange rate movements.
Overview
Before we look at these forces, we should sketch out how exchange rate
movements affect a nation's trading relationships with other nations. A higher
currency makes a country's exports more expensive and imports cheaper in
foreign markets; a lower currency makes a country's exports cheaper and its
imports more expensive in foreign markets. A higher exchange rate can be
expected to lower the country's balance of trade, while a lower exchange rate
would increase it.
Determinants of Exchange Rates
Numerous factors determine exchange rates, and all are related to the trading
relationship between two countries. Remember, exchange rates are relative, and
are expressed as a comparison of the currencies of two countries. The following
are some of the principal determinants of the exchange rate between two
countries. Note that these factors are in no particular order; like many aspects of
economics, the relative importance of these factors is subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a
rising currency value, as its purchasing power increases relative to other
currencies. During the last half of the twentieth century, the countries with low
inflation included Japan, Germany and Switzerland, while the U.S. and Canada
achieved low inflation only later. Those countries with higher inflation typically
see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates. (To learn
more, see Cost-Push Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation and

exchange rates, and changing interest rates impact inflation and currency values.
Higher interest rates offer lenders in an economy a higher return relative to
other countries. Therefore, higher interest rates attract foreign capital and cause
the exchange rate to rise. The impact of higher interest rates is mitigated,
however, if inflation in the country is much higher than in others, or if
additional factors serve to drive the currency down. The opposite relationship
exists for decreasing interest rates - that is, lower interest rates tend to decrease
exchange rates. (For further reading, see What Is Fiscal Policy?)
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services, interest
and dividends. A deficit in the current account shows the country is spending
more on foreign trade than it is earning, and that it is borrowing capital from
foreign sources to make up the deficit. In other words, the country requires more
foreign currency than it receives through sales of exports, and it supplies more
of its own currency than foreigners demand for its products. The excess demand
for foreign currency lowers the country's exchange rate until domestic goods
and services are cheap enough for foreigners, and foreign assets are too
expensive to generate sales for domestic interests. (For more, see Understanding
The Current Account In The Balance Of Payments.)
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to
foreign investors. The reason? A large debt encourages inflation, and if inflation
is high, the debt will be serviced and ultimately paid off with cheaper real
dollars in the future.
In the worst case scenario, a government may print money to pay part of a large
debt, but increasing the money supply inevitably causes inflation. Moreover, if a
government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply
of securities for sale to foreigners, thereby lowering their prices. Finally, a large
debt may prove worrisome to foreigners if they believe the country risks
defaulting on its obligations. Foreigners will be less willing to own securities
denominated in that currency if the risk of default is great. For this reason, the
country's debt rating (as determined by Moody's or Standard & Poor's, for

example) is a crucial determinant of its exchange rate.

5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to
current accounts and the balance of payments. If the price of a country's exports
rises by a greater rate than that of its imports, its terms of trade have favorably
improved. Increasing terms of trade shows greater demand for the country's
exports. This, in turn, results in rising revenues from exports, which provides
increased demand for the country's currency (and an increase in the currency's
value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can cause
a loss of confidence in a currency and a movement of capital to the currencies of
more stable countries.
Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its
investments determines that portfolio's real return. A declining exchange rate
obviously decreases the purchasing power of income and capital gains derived
from any returns. Moreover, the exchange rate influences other income factors
such as interest rates, inflation and even capital gains from domestic securities.
While exchange rates are determined by numerous complex factors that often
leave even the most experienced economists flummoxed, investors should still
have some understanding of how currency values and exchange rates play an
important role in the rate of return on their investments.

What Determines Exchange Rates:

If I visit an exchange rate site such as XE.com, it will tell me that 1 U.S. dollar is trading for 0.67
euros. But how is this exchange rate determined? What gives the U.S. dollar this value when priced in
euros?

Short Run Exchange Rates are Determined by Supply and

Demand:
Like any other price in our economy, exchange rates are determined by supply and demand specifically the supply and demand for each currency. But that explanation is almost tautological - we
need to know what determines the supply of a currency and the demand for a currency.

What Determines the Demand for a Currency?:

The supply of a currency on a foreign exchange market is determined by the following:

Demand for goods, services and investments priced in that currency. If I want to buy
Canadian bonds or Canadian maple syrup, then I will need Canadian dollars to do so. If total
expenditures, by non-Canadians, on these items rise, the demand for the Canadian dollar will
rise.

Speculators. If I believe, for whatever reason, the Canadian dollar will rise in value in the
future, I will want to buy more Canadian dollars today.

Central banks - Occasionally central banks will buy up a foreign currency to affect the
exchange rate.

What Determines the Supply of a Currency?:

The supply of currency is affected by the following:

Demand for goods, services and investments priced in a different currency. If I want
Canadian maple syrup, I will need Canadian dollars. To get Canadian dollars, I will have to
supply a currency in return, such as yen or U.S. dollars.

Speculators. If I believe, for whatever reason, the Canadian dollar will fall in value in the
future, I will start to sell off my Canadian dollars today (that is, supply them to the market).

Central banks through increases in the money supply. See: Why Not Just Print More Money?

What Should The Currency Be Worth?:

If speculators can affect both the supply and demand for a currency, they can ultimately affect the
price. Thus does a currency have an intrisic value relative to another currency? Is there a level the
exchange rate should be at?
It turns out there is at least a rough level to which a currency should be worth - please see A
Beginner's Guide to Purchasing Power Parity Theory. The exchange rate, in the long run, needs to be
at the level which a basket of goods costs the same in two currencies. Thus if a Mickey Mantle rookie
card costs $50,000 Canadian and $25,000 US, the exchange rate should be 2 CDN = 1 US.

Fluctuations in exchange rates[edit]

A market-based exchange rate will change whenever the values of either of the two component
currencies change. A currency will tend to become more valuable whenever demand for it is
greater than the available supply. It will become less valuable whenever demand is less than
available supply (this does not mean people no longer want money, it just means they prefer
holding their wealth in some other form, possibly another currency).[7]
Increased demand for a currency can be due to either an increased transaction demand for money
or an increased speculative demand for money. The transaction demand is highly correlated to a
country's level of business activity, gross domestic product (GDP), and employment levels. The
more people that are unemployed, the less the public as a whole will spend on goods and
services. Central banks typically have little difficulty adjusting the available money supply to
accommodate changes in the demand for money due to business transactions.
Speculative demand is much harder for central banks to accommodate, which they influence by
adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is
high enough. In general, the higher a country's interest rates, the greater will be the demand for
that currency. It has been argued[by whom?] that such speculation can undermine real economic
growth, in particular since large currency speculators may deliberately create downward pressure
on a currency by shorting in order to force that central bank to buy their own currency to keep it
stable. (When that happens, the speculator can buy the currency back after it depreciates, close
out their position, and thereby take a profit.

How is the exchange rate determined?

The exchange rate changes from day to day, hour to hour, even minute to minute Why is that?
Just like the market for any good, the exchange rate is determined by supply and demand!
Lets say there are only two countries in the world: the US and the EU. There exists a market
for US dollars in the world. There is a certain amount of dollars that Europeans want and a
certain number of dollars that Americans want to make available to Europeans. The price in
this market is the nominal exchange rate if the exchange rate is high, Europeans want less
(just as you would buy less apples if they were expensive), and Americans want to make more
available because they will get more for it (they are like the apple grower). Where supply equals
demand we get an equilibrium exchange rate and quantity of dollars bought and sold in the
foreign exchange market.

As the demand and supply of dollars in the foreign exchange market moves around, so does the
exchange rate!
If either demand rises (shift right) or supply falls (shift back) the nominal exchange rate
appreciates (e goes up)
If either demand falls (shift left) or supply rises (shift out) the nominal exchange rate
depreciates (e goes down)
What leads to changes in demand and supply?

Changes in trade

The supply of dollars is determined by US demand for imports from the EU.

The demand for dollars is determined by EU demand for US exports.

Example: If the EU loses interest in buying US goods, then the demand for US exports
will fall, as will the demand for US dollars in the foreign exchange market, and the dollar
will depreciate. The Europeans need fewer dollars because they are buying fewer
American goods.

Speculation / foreign exchange traders

Some people buy and sell currencies to make a profit if they can buy a
currency when the exchange rate is low and sell the currency when the
exchange rate is high, they will make money.

Speculators guess as to what the exchange rate will be in the future and
buy and sell according to that guess, either demanding more or less
dollars or supplying more or less dollars.

Example: If speculators think that the exchange rate of the dollar will be less next week,
they will try and sell their dollars now. This increases the supply of dollars in the foreign
exchange market and the dollar will depreciate.

Determining exchange rates

There are a number of methods that can be used to determine an exchange rate:
a. A flexible or floating exchange rate is where the market forces of supply and demand
determine the exchange rate.
b. A fixed exchange rate is where the government determines the exchange rate for a
period of time based on the value of another countrys currency such as the US dollar.
c. A managed exchange rate is where the government intervenes in the market to
influence the exchange rate or set the rate for short periods such as a day or week.

a. Flexible (or floating) exchange rates

Under a flexible or floating exchange rate the value of a countrys currency changes
frequently, even by the minute. The market rate will depend on the demand for, and
supply of, that currency in the forex markets. When there is no intervention in the free
market operations by a government agency a clean float is said to exist.
Figure 1

The determination of the exchange rate under a floating exchange rate is shown in figure
1.
The demand curve (DD) indicates the quantity of Australian dollars that buyers (those
people who hold US dollars) are willing to purchase at each possible exchange rate.
The supply curve (SS) shows the quantity of Australian dollars that will be offered for
sale (those people who hold Australian dollars) at each exchange rate.

At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied
and demanded is Q1 Australian dollars. At an exchange rate above equilibrium, such as
$A1.00 = $US0.60, an excess supply of Australian dollars exists and market forces will
force the exchange rate down towards equilibrium.
If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demand
situation exits and market forces will put upward pressure on the value of the Australian
dollar.
Remember that there are many different exchange rates. The following examples
illustrate how an appreciation (increase in value) or depreciation (decrease in value)
of the Australian dollar against the US dollar has been created by changes in
demand and supply conditions.
i.

A currency appreciation
Figure 2

a. In Figure 2a there has been an increase in demand (DD to D1D1) for

Australian dollars. This has led to an increase (appreciation) in value of
the Australian dollar from $US0.50 to $US0.60 and the quantity of
Australian dollars traded has also increased from 0Q to 0Q1.
The shift in the demand curve could have been caused by an increase in
the demand for Australian exports, such as coal, aluminum, beef or lamb

b. In Figure 2b there has been a decrease in the supply (SS to S1S1) of

Australian dollars. This has led to an increase in the value (appreciation)
of the Australian dollar from $US0.50 to $US0.60. However the quantity
of Australian dollars traded has decreased from 0Q to 0Q1.
This decrease in the supply of Australian dollars may have been caused by
a recession, slowing the demand for imports.
ii.

A currency depreciation
Figure 3

a. In Figure 3a there has been a decrease in demand (DD to D1D1) for

Australian dollars. This has led to a depreciation in the value of the
Australian dollar from $US0.50 to $US0.40. The quantity of Australian
dollars traded has also decreased from 0Q to 0Q1.
The decrease in the price of Australian dollars in terms of US dollars
could have been generated by a slow down in global economic activity, so
decreasing the demand for Australian exports, or because of foreign
investors lacking confidence in the Australian economy and investing
elsewhere.
b. Figure 3b indicates an increase in supply of Australian dollars with the
supply curve moving from SS to S1S1. Again the value of the Australian
dollar has decreased from $US0.50 to $US0.40 while the quantity of
Australian dollars traded has increased from 0Q to 0Q1.

The depreciation may have resulted from strong domestic economic

growth increasing the demand for imports, or from higher overseas
interest rates, causing a capital outflow from Australia.

b. Fixed exchange rates

The World Bank and the IMF were both established in 1944 at a conference of world
leaders in Bretton Woods, New Hampshire (USA). The aim of the two "Bretton Woods
institutions" as they are sometimes called, was to place the global economy on a sound
footing after World War II. To help reduce the economic instability that existed the
conference favoured the use of a fixed exchange rate system.
Under a fixed exchange rate system the value of a countrys currency is fixed by the
government or one of its agencies, for example the Reserve Bank of Australia (RBA) to
another currency for a specific time period.
This method of determining exchange rates was to dominate until the 1970s.
In Australia the dollar was fixed (pegged) from 1946 to December 1971 to the British
pound and then to the US dollar until September 1974.
From September 1974 to November 1976 the Federal Government, in an attempt to
reduce the impact of exchange rate fluctuations on the economy pegged the Australian
dollar to the trade weighted index (TWI).
Using this system the value of the Australian dollar was allowed to adjust against each
currency in the TWI. However in reality the value of the Australian dollar remained fixed
for long periods of time.
Click here for more on the TWI
Figure 4

In Figure 4 the official exchange rate has been fixed at a level of $A1.00 = $US0.60,
which is above the market rate of $A1.00 = $US0.50. For the exchange rate to be fixed at
a level higher than the market rate requires official intervention by the Reserve Bank of
Australia.
At this level the RBA would have to buy the excess supply of Australian dollars
equivalent to Q1Q2 at a price of $US0.60. To buy the surplus of Australian dollars the
government would need to sell its reserves of foreign currency.
A fixed exchange rate system does not imply that the rate will stay at that same level all
the time. The government may decide to change the rate because of adverse effects on the
economy. For example, if the currency is overvalued exporting industries will become
less internationally competitive, affecting international trade and the balance of payments
and the government might take action to devalue the exchange rate.
A devaluation of a currency occurs under a fixed exchange rate system when there is
deliberate action taken by a government to decrease its value in the forex market.
OR
Alternatively a revaluation occurs under a fixed exchange rate system when there is
deliberate action taken by the government to increase the value of the currency in the
forex market.

c. Managed exchange rates

A managed exchange rate occurs when there is official intervention by a government or
an agency such as the RBA to determination the value of a countrys exchange rate.

Through such official interventions it is possible to manage both fixed and floating
exchange rates.
The Australia dollar was pegged to TWI from September 1974 to November 1976. Then
in November 1976, the government adopted a managed flexible peg or a crawling
peg system. Under this new method of determining exchange rates, the value of the
Australian dollar was changed relative to the TWI, not just relative to a single individual
currency
The exchange rate was announced each morning by the RBA and remained at that rate
until the next morning. This system continued until the Australian dollar was floated in
December 1983.
Under the floating exchange rate system the value of the Australian dollar is not
specifically targeted by the RBA. To intervene in the market and alter the exchange rate
significantly in the long run is beyond the financial ability of the RBA. This is because
Australias level of foreign reserves (gold and foreign currencies) are relatively small
(A$34 billion) compared to volumes of currency trade in the market each day.
However the RBA may decide to enter the foreign exchange market as either a buyer or
seller to stabilise any short-term fluctuation in the value of the Australian dollar. To limit
a fall in the value of the Australian dollar (depreciation) the RBA will buy Australian
dollars, and to prevent a rise in the value of the Australian dollar, the RBA will sell
Australian dollars in the market.
Such intervention by the RBA is known as a dirty float, or more correctly a
managed float.

Review exercises
Exercise 1
The following table indicates the value of one Australian dollar in terms of New Zealand dollars
and Japanese yen over a two day period.
Currency

Day 1

Day 2

Japanese yen

69.0

65.0

New Zealand
dollars

1.20

1.25

i.

What has happened to the value the Australian currency from day one to day two?

Answer
ii.

All other things being equal, how would a movement in the value of the Australian dollar
from $A1.00 = $NZ1.20 to $A1.00 = $NZ1.25 affect Australian producers and
consumers?
Answer

Exercise 2
The following diagram shows a hypothetical forex market for Australian dollars.

The Federal Government for economic reasons has decided to intervene in the market and
maintain the exchange rate at $A1.00 = US$0.55.